Investor Portfolio Climate Risks to Grow 10% Over Next 20 Years

Investor Portfolio Climate Risks to Grow 10% Over Next 20 Years

[Editor's note: This article originally appeared at SocialFunds.com and is reprinted with permission.]

Asserting that "investors cannot simply rely on a best guess as to how the future will unfold when planning their investments," Mercer has published a report that states, "Institutional investors must develop new tools to more effectively model systemic risks such as climate change."

Warning that the quantitative analysis of traditional asset allocation fails to account for the potential impacts of climate change, the report, entitled "Climate Change Scenarios -- Implications for Strategic Asset Allocation," states, "Historic precedent is not an effective indicator of future performance." According to the report, the economic cost of climate policy could lead to as much as a 10 percent increase in portfolio risk in the next 20 years.

The report points out that at present, the short-term horizon of most equity and bond investments prevents investors from factoring in the long-term risks and opportunities relating to climate change. Furthermore, allocating assets to more conservative investment products is unlikely to be helpful, and may in fact reduce returns on investment.

Instead, the report continued, investors should assess qualitative inputs such as investment opportunities in low carbon technologies, the effect on investment of changes to the physical environment, and the effect of policy on the cost of carbon.

"Climate-related policy changes could increase the cost of carbon emissions by as much as $8 trillion over the coming 20 years," Danyelle Guyatt, head of global research for the Responsible Investment team at Mercer, said. "The longer the delay, and the poorer the coordination in implementing the changes, the more uncertainty there will be for investors. The cost of impacts to the physical environment could exceed $4 trillion."

"Our findings had three broad objectives," Guyatt continued. "First and foremost, we wanted to investigate and analyze in detail the potential investment risks resulting from climate change. We also wanted to look at the key performance drivers for many of the leading markets and regions around the world that our clients are invested in. And third, we wanted to identify the scenarios around climate change that will help us better understand and frame climate change as a strategic investment priority."

By "increasing investment in mitigation and adaptation efforts globally," the report finds, institutional investors can both serve the financial interests of beneficiaries and help address climate change. A typical portfolio seeking a 7 percent return on investment, for instance, "could manage the risk of climate change by ensuring around 40 percent of assets are held in climate sensitive assets," according to the report.

While climate-sensitive assets may, in some cases, be more risky as standalone investments, the report continues, portfolio risk can actually be reduced by investment in assets directed toward mitigation and adaptation.

"Investment opportunities in low-carbon technologies could be as high as $5 trillion by 2030," Guyatt said.

An effective way of managing portfolio risk at present is passive investment in sustainable indexes, according to the report. Other steps that institutional investors can take immediately include the introduction of climate risk assessment into strategic reviews, as well as encouraging fund managers to proactively manage climate risks.

Investors should also act on their responsibilities of active ownership by engaging with companies in their portfolios to encourage the incorporation of climate-related risks and opportunities into business operations.

Perhaps of especial importance, according to the report, is "the need for investors to communicate with policymakers the need for a clear, credible and internationally coordinated policy response" to climate change.

Without clearly articulated policies addressing climate change, the report warns, investment volatility will increase, and many investors will delay investment in low-carbon technologies until such policies are in place.

"While many institutional investors might view engagement with policymakers as a separate function from strategic decision-making processes," the report states, "It can play a vital role in overall portfolio risk management."

Said Guyatt, "The report is about setting the framework for how institutional investors can adapt to the transformation" to a low-carbon economy.

Responding to the report, Mindy Lubber, president of Ceres and director of the Investor Network on Climate Risk (INCR), said, "No prudent investor can disregard a risk as great as 10 percent on portfolio performance, no matter how nontraditional the source of that risk may be. At the same time, no prudent investor can ignore the potential for low-carbon investment opportunities that could be as high as $5 trillion by 2030."

"For a truly effective investment response," Lubber continued, "Policy makers and regulators must ensure that investors have the information they need from companies to make prudent investment decisions. Equally important, policymakers must enact carbon-reducing policies that investors need for shifting large amounts of capital toward low-carbon technologies and away from higher-polluting technologies."